Mba fm 02 - security analysis and portfolio---introduction

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PGDM FM 04-- Security analysis and Investment management

By : Aniruddha Ghosh

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INTRODUCTION

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Topics for today’s discussion

• What is Security Analysis and Portfolio Management all about?

• Why should we read this subject in a course like MBA , PGDM , CFA and other professional courses?

• What is the relation of this subject with other fields?• What is a Stock?• What is a Share ?• What is a market ? Classification of markets.• What are the various types of markets available in

India?

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What is a Stock?

• When an investor gives a corporation money in return for part of ownership, the corporation issues a certificate of ownership interest to the stock holder. This certificate is known as stock certificate, Capital stock or Stock.

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What is a share?

• Some investors have large ownership interests in a given corporation, while other investors own a very small part. To keep track of each investor’s ownership interest, corporations use a unit of measurement referred to as a “Share” (or “share of stock”).

• The no. of shares that an investor’s own is printed on the investor's stock certificate.

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Types of stock --- in terms of returns

• Blue Chip stocks• Green chip stocks• Red chip stocks• Growth stocks• Cyclical stocks• Fixed income stocks• Stable stocks

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• Infra stocks• Banking stocks• PSU stocks• IT stocks• FMCG stocks• Cement Stocks• Automobile stocks• Steel Stocks• Oil stocks

Types of stock --- in terms of sector

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Relation of SAPM with other fields of study

• Economics• Mathematics esp. statistics• Science esp. Brownian movement• English literature• Psychology esp. human behavior• Politics

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What is Investment?

• In layman terms it is the process of sacrificing something now for the prospect of gaining something later.

• As per Graham & Qadd- “ An investment operation is one which upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative”. So from the above lines we can infer that investment means some monetary commitment for adequate return in future.

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Characteristics & Objectives of Investment

• Risk • Safety• Return • Liquidity• Marketability• Concealability• Capital growth • Purchasing power ability

• Stability of income•Tax benefits

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Scope of Investment

• Safety of principal• Liquidity & collateral value• Stability of income• Purchasing power• Adequacy of income after tax• Capital growths• Legality• Possible appreciation • Tangibility• Conceivability

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NEED & IMPORTANCE OF INVESTMENT

• Longer life expectancy• Increasing rates of taxation • Interest rates• Inflation• Income• Investment channels

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Approaches to investment decision making

• Fundamental approach • Psychological approach• Academic approach• Eclectic approach

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Investment Process

• Step 1:– Generating Utility function , bearing the following things

into mind;• Client analysis i.e. risk taker or averser • Investment horizon• Tax code

• Step 2: – Asset allocation, taking into a/c the following factors;

• A view on markets• An analysis of various asset classes i.e., Shares , debt ,G.Secs, etc.• in domestic or international market• Taking inflation factor into effect.

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• Step 3:– Security selection

• Which share?• At what price?• At what time?• Valuation bases:

– Comparable ratios– Cash flows– Charts– indicators

• Private information

Investment Process (contd.)

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• Step 4:– Execution; while asking a few questions to yourself or

the investor;• How often do you trade?• How large do you trade?• Do you use instruments such as Derivatives to hedge

against trade?• Trading costs

– Commission – Brokerage– Bid/ask spread

• Trading systems


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• Step 5:– Performance Evaluation; again asking a few

questions;• How much risk did the portfolio manager take?• What return did the portfolio manager make?• Did the portfolio manager outperform / underperform?• Market Timing• Stock selection


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Investment Activities

• FINANCIAL ASSETS– Cash, bank deposits, PF, LIC scheme, Pension

Schemes, PO certificates & Deposits.• PHYSICAL ASSETS

– House, land, building , bullion , consumer durables, etc.

• MARKETABLE SECURITIES– Shares, bonds, & G.Secs

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Investment Alternatives

• Non-marketable financial assets– PFs, Bank Deposits, Insurance , PO Deposits, NSC,

Company Deposits.• Marketable financial assets

– Equity Shares, Bonds, Money market instruments like (T-Bills, Commercial Papers, ICDs)

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Investment Alternatives

• Non-marketable financial assets– PFs, Bank Deposits, Insurance , PO Deposits, NSC,

Company Deposits.• Marketable financial assets

– Equity Shares, Bonds, Money market instruments like (T-Bills, Commercial Papers, Certificate of Deposits), MFs, Real Estate, Precious Objects, Financial Derivatives.

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What do you mean by the term “Market” ?

• Definition as per ‘Oxford Lexicon’– A common place where buyers and sellers meet to exchange goods against a common denomination (currency).

• Definition in terms of Finance – A place where financial instruments are traded under a legalized body following certain norms against a denomination (currency).

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Different types of market

• The capital market• The credit market• The money market• The FOREX market• The commodity market

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Market Snapshot TableSEGMENT PURPOSE PLAYERS REGULATORS

Money market ST finance, high liquidity, maturity period of funds (1 day – 1 year)

Banks, FIs, Govt., FIIs, Corporate, MFs, Individuals

RBI

Capital Market LT finance, maturity period of funds ( > 1 year) , liquidity depends on the term of the financial asset.

Banks, FIs, Govt., FIIs, Corporate, MFs, Individuals

SEBI

Forex Market Both ST & LT finance in foreign currency

Banks, Corporates , Forex Dealers

RBI

Credit Market Both ST & LT finance, Provides loan of ST & MT to corporate & individuals.

Banks, FIs, NBFCs RBI

Commodity Market

Exchange of Commodities esp. metals

Corporate, Broking houses

SEBI

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Role of Financial Intermediaries

• Transfer of funds from lender to borrower.• They generally eases the flow of fund in the

market.• The presence of intermediaries increases the

cost of lending and borrowing.• they help in the issuance of securities• They help to migrate risk of the Co. whose

securities are going to be issued.

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List of some Intermediaries Operating in Financial markets

Intermediary Market Role

1. Stock Exchange Capital market Secondary market to securities.

2. Investment Bankers

Capital Markets Corporate advisory services, issue of securities.

3. Underwriters Capital market & Money Market

Subscribe to unsubscribed portion of securities.

4. Registrars, Depositories, Custodians

Capital Markets Issue securities to the investors on behalf of the Co. & handle share transfer activity

5. Primary Dealers Money Market Market making in G.Secs.

6. Forex Dealers Forex Market Ensure exchange in currencies.

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Stock Exchange

• Let us understand this term through KWA method, the term “stock exchange” comprises of 2 words – stock & exchange. As discussed earlier, Stock means a fraction of capital of a company & the word exchange means a place for purchase and selling.

• The Securities Contract Regulation Act 1956 defines a “Stock Exchange” as an association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities.

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Stock Exchange (Contd.)

• According to Hastings “ Stock Exchange or security market comprises all the places where buyers and sellers of stocks and bonds or their representatives, undertake transactions involving sales of securities”.

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Characteristics of Stock Exchange

• Place of transaction • Voluntary AOP• A platform for business• A custodian• Autocracy & draconianism• Large no. of official & unofficial bodies are

connected.

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Functions of Stock Exchange

• Ready market• Mobilization of savings• Evaluation of securities• Capital formation• Proper channelization of capital• Fair dealings• Control of corporate sector• Barometer of business progress

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Advantages / Benefits of Stock exchanges

• Benefits to the Cos.• Benefits to the investors• Benefits to the community or society• Limitations of Stock Exchange

– Lack of uniformity and control– No restriction in membership– Gap in regulations

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Markets under Stock Exchanges in India

• Primary Market • Secondary Market

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Primary Market vs. Secondary MarketFeature NIM Secondary market

1. Issue of securities

Deals only with new issue of securities. Issues are considered fresh or new provided such issues are made for the first time either by the existing co. or by the new co.

Deals in existing securities

2. Location No fixed geographical location needed.

Needs a fixed place to house the secondary market activities , viz., trading.

3. Transfer of securities

Securities are created & transferred from corporates to investors for the first time.

Securities are transferred from one investor to another through stock exchange mechanism.

4. Entry All Cos. can enter NIM and make fresh issue of securities.

For the securities to enter the portal of stock exchanges for the purpose of trading listing is mandatory.

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Feature NIM Secondary market

5. Administration Has no tangible form of administrative set up.

Has a definite form of administrative set-up that facilitates trading in securities.

6. Regulation Subject to regulations mostly from outside company– SEBI, Stock Exchanges, Cos Act ,etc.

Subject to regulation both from within & outside the stock exchange framework.

7. Aim Creating LT investments for borrowing.

Providing liquidity through marketability of those instruments.

8. Price movement

Stock price movement in secondary market influences the pricing of issues.

Both macro & micro factors influence the stock price movement.

9. Depth Depends on number and the volume of issue.

Depth depends upon the activities of the primary market as it brings into the fore more corporate entities and more instruments to raise funds.

Primary Market vs. Secondary Market [contd.]

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Types of Public Issues

MARKETS

SECONDARY

NIM

NIM- Methods of marketing securities

NIM- Methods of marketing securities

PPM = Private placement methodPPM= Pure Prospectus methodOSM = Offer for Sale methodIPOM = IPO methodRIM = Rights Issue methodBIM = Bonus issue methodBBM = Book Building methodSOM= Stock Option MethodBODM= Brought-out Deals method

PPM OSM PPM IPOM

BODMSOMBBMBIMRIM

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Markets Available in India

• NSE– Nifty 50, Nifty futures, NSE 100, etc.

• BSE– SENSEX, BSE BANKEX, BSE 500, BSE 100, BSE

FMCG , etc. • OTCEI

– Bullion , metals, commodities.

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Listing of Securities• Listing means admission of securities to dealings

on a recognized stock exchange of any individual co., central and state governments , quasi governments and other FIs , etc.

• Advantages of listing:– 1. To the company:

• Tax concessions• National & international presence• Term loan facility from both domestic and non-domestic

banks• Mobilizing resources• Ensures wide share holding pattern

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• Advantages of listing: (contd.)– 2. To the Investors

• Ensurement of liquidity• Rights entitlement• Loan factor• Tax assessment• Avoidance of secrecy• Investors protection• Publication of quarterly reports• M&A, takeover offers enables investors to exercise their

discretion.

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Functions of SEBI• Regulating the business• Registering & regulating the working of workers who are associated with securities

market• Registering & regulating the workings of depositories, participants, custodian of

securities, FIIs, credit rating agencies, etc.• Registering & regulating the working of venture capital funds & collective investment

schemes including MFs. • Prohibiting fraudulent & unfair trade practices relating to securities market.• Promoting investor’s education & training.• Prohibiting insiders trading in securities• regulating substantial acquisition of shares & takeover of Cos.• Performing of such functions & exercising such powers under the Securities Contracts

(Regulation) Act 1956, as may be delegated to it by the Central Govt.• Levying fees or other charges for carrying out the regulations in Securities market. • Conducting research relating to securities market.• Registration of FIIs.

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Powers of SEBI• The discovery & production of any books of a/c or documents.• Summarizing & enforcing the attendance of persons & examining them on oath.• Inspection of any books, registrars and other documents of co. or any public co.

intending to get its securities listed on a stock exchange where the board suspects the co. to be involved in insider trading/ fraudulent & unfair trade practices related to the securities market.

• Issuing commission for the examination of witnesses or documents.• During an investigation / a pending enquiry, in order to protect the interest of

the investors or the securities market, the board may:– Suspend trading of a stock in a stock exchange.– Restrict persons in trading securities.– Suspend any office bearer / self regulatory authority of the stock exchange.– Impend any or retain the proceeds of securities of any transaction under investigation .– Attach after the specified process, for a period not exceeding 1 month, the bank a/c s or

any other intermediary or person associated with the securities market in a matter involving violation of the provisions of the SEBI Act.

– Direct any intermediary or person associated with securities market not to dispose off or alienate an asset forming past of any transaction under investigation.

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• The board may specify the requirements for listing & transfer of securities

• w.r.t. to prospectus, offer documents & advertisements soliciting money, the board may for the protection of investors;– Specify by regulation:

• Matters relating to issue of capital transfer of securities & matters incidental there to.

• The manner in which such matters are disclosed

– Specify by special orders:• Prohibit any co. from issuing prospectus any offer document or issue

advertisement, soliciting money for issue of securities• Specify the conditions subject to which these documents can be issued

Powers of SEBI [contd…]

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NSE at a Glance• Inception date: 3rd Nov. 1994 in Mumbai • Type of trading: NEAT (National Exchange for Automated Trading)• Clearing house: NSCCL (National Securities Clearing Corporation Ltd.)• > than 800 trading members • Largest trading VSAT network worldwide• Trading terminals spread across 379 cities with more than 6,500

concurrent uses daily.• Min. market capitalization of Rs. 5 billion in order to get included in the

index.• Other bodies, S&P CNX Defty (Dollar-denominated version of Nifty). Nifty

Junior (comprising 50 stocks which are highly liquid in nature).• S&P CNX 500, India’s first broad-based benchmark, representing 90% of

the total market capitalization & about 98% of NSE ‘s total turnover.

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BSE at a Glance• Oldest stock exchange in Asia, established in 1875 in the

name of “The Naïve share & stock Brokers Association”. • In 1956 BSE became the 1st Stock exchange to be recognized

by the Indian Govt. under Securities Contract regulation Act. • The main BSE sensex Index comprises of 30 scrips. • Other stock indices of BSE are BSE 500, BSEPSU, BSE MIDCAP,

BSE SMLCAP & BSE BANKEX• Clearing house: BOISL (Bank of India Shareholding Ltd.)• Type of trading : BOLT (BSE Online Trading)

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Methods of trading system in Stock Exchanges

• Online stock market trading– Installable software based stock trading– Web based trading application

• WAP trading– Wireless Application Protocol

• SLB Scheme – Standardized contracts– Introduced by SEBI, 1997 to provide mechanism for borrowing of

securities to enable settlement of securities sold short.– Clients needs to be registered with approved intermediaries– Tenure of contracts = 7 days– Settlement period = t +1 days

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Short Selling• Short selling can be defined as selling a stock

which the seller does not own at the time of trade. Short selling is the sale of a security that is not owned by the seller, but with a promise to deliver the same.– 20th Dec. 2007, SEBI allowed this short selling– Types of short selling:

a) Naked short selling- No intention of returning the shares / delivery.

b) Day trading / Intraday Trading.

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Short Selling Explained

• Sale of 100 shares of X Ltd. @ Rs. 60/- each

SALEAI under SLB Scheme

Settlement of 100

shares of X Ltd.

Borrowing of 100

shares of X Ltd.

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Types of trading [ Contd….]

• Screen based trading system (SBTS)• Scripless trading

– Settlement takes place via book entry instead of physical exchange & delivery of securities certificates.

– Advantages:• Decrease in paper work of stock brokers & stock exchanges• Safety from theft, fakeness & mutilation.• Improves liquidity• Greater speed of exchange of securities certificate• Decrease in cumbersome transfer procedures

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Demat Trading / Dematerialization of Shares

• Regulated by “ the Depositories Act , 1996”• The various participants are:

– NSDL (National Securities depository Ltd.)– CDSL (Central depository services Ltd.) – DPs– Registrars & share transfer agents– Investors

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Alternative trading system (ATS)Firm B (Buyer)

Evincing interest in buying of shares . Places an order for buying on seller’s site.

FIRM A (Seller)Puts a message on his site for the availability of WIPRO securities @ Rs. 100/-

CONFIRMATION

• ATS software will confirm the availability of securities from the sellers DP a/c balance in bank a/c of the buyer.

ESCROW a/c

• ATS software generates 2 escrow a/c ( A type of A/c where legal money is kept separately for some definite course of action here it is mainly trading of securities); one of seller “for securities” & other of buyer “for funds”.

RECONFIRMATION

• ATS software will flash a message on the screen of both buyer and seller to reconfirm their willingness.

EXECUTION

• Upon reconfirmation of willingness by both the parties, ATS software will settle the obligations of both parties instantly & simultaneously.

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SEBI (Disclosure & investors protection)

• The guidelines consists of framework of capital issuances as follows:– Preliminary ( chapter –I)– Eligibility Norms for Cos. Issuing securities ( Chapter –II)– Pricing by Cos. Issuing securities (Chapter-III)– Promoter’s contribution & lock-in requirements (Chapter- IV)– Pre-Issue Obligations (Chapter – V)– Contents of offer documents (Chapter – VI)– Issue of IDRs ( Chapter VIA)– Post Issue Obligations (chapter- VII)– Other issue requirements (Chapter – VIII)– Green Shoe Option (Chapter- VIIIA)

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– Guidelines on advertisements (Chapter-IX)– Guidelines for Issue of debt instruments (Chapter –X)– Guidelines on Book Building (Chapter XI)– Guidelines on E-IPO (Chapter XIA)– Guidelines on issue of capital by designated financial institutions (Chapter

XII)– Shelf prospectus (Chapter XIIA)– Guidelines for Preferential issues (Chapter XIII)– Guidelines for QIPs (Chapter XIIIA)– Guidelines for OTCEI issues ( Chapter XIV)– Guidelines for Bonus issues (Chapter XV)– Operational Guidelines (Chapter XVI)– Miscellaneous (Chapter XVII)

SEBI (Disclosure & investors protection) [contd…..]

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Types of OrdersA. Orders at BSE Limit order Market order Stop loss orderA. Orders at NSE

Time related conditions: Day order GTC order / open orders GTD order IOC order

Price related conditions: Limit order Market order Stop loss order

Quantity conditions: DQ Order MF order AON order

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Some Confusing terms

• Investor• Investment • Speculator

– Types of Speculators :• Bull / Tejiwala• Bear / mandiwala• Stag• Lame duck

• Speculation• Gambling• Arbitrageur• Arbitrage

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Risk & Return Analysis

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Understanding the concept of Return

• Return can be defined as the motivating force, inspiring the investor in the form of rewards, for understanding the investment.

• There are 2 components of return – Yield – Capital appreciation

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Types of return

• Post returns• Ex-ante returns• Actual return • Expected return• Estimated return• Average return

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How to calculate return?

• Measuring Historical or Ex-post returns:

– Where,• r=required rate of return• D= yield• Pn= Price of the Security/bond at the end of the holding

period/ at the time of sale• Po=Price of the security / bond at the beginning of the

holding period / at the time of purchase.

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Case to watch for

• Case 1– If a share of ACC ltd. Is purchased for Rs 3580/- on 8th

Feb last year , and sold for Rs 3800/- on 9th Feb this year and the co paid a dividend of Rs 35/- for the year. What is the rate of return in the hands of the investor?

• Case 2– Mr. X purchased Rs 1000/- par value bond for Rs

900/-. The coupon rate on this bond is 8% p.a. one year later he sells the bond for Rs 800/-. Calculate the rate of return for Mr. X.

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• Measuring Expected Return:

– Where,– x=No. of events / securities

How to calculate Probability return?

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Illustration

• Calculate the expected return for stock A from the following information:

• Return (%) -24 -10 0 12 18 22 30

Probability of

Occurrence

0.05 0.15 0.15 0.20 0.20 0.15 0.10

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A few more concepts

• Portfolio• Portfolio theory• Asset allocation

– Traditional allocation – Core-satellite allocation– Reverse asset allocation

• Portfolio management

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Measuring expected return on a Portfolio• The expected return on a portfolio of securities is

nothing but the weighted average of the return on individual securities in the portfolio.

• The expected return on portfolio can be calculated as under:

• Where, – = The proportion of investment in asset x.– = The expected return on asset x.– n=The total no. of assets in the portfolio– =Expected portfolio return.

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Illustration Stock Price as on

1/4/2001Price as on 31/3/2002

Yearly dividend

X 20 30 2

Y 30 40 3

Z 50 60 5

From the above table calculate the rate of return on each stock and also calculate the portfolio return.

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Understanding the term Risk

• Definition of Risk– As per “Oxford lexicon” the term risk means the

possibility of loss.– As per Security Analysis the term Risk can be

defined as – “the future happening that can be assumed under the probability of the likelihood of future outcomes that can be quantified”.

• So, what is Uncertainty?– It refers to what will happen in future & it cannot be

quantified.

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Types of Risk

Systematic

Market risk

Interest rate risk

Purchasing power risk

Internal Risk

External Risk

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Types of Risk (contd.)Cases of Internal Business Risk Cases of External Business Risk

1. Fluctuation in sales2. R&D3. Personnel management4. Fixed cost 5. Single product

1. Social & regulatory factors

2. Political risk3. Business cycle4. Exchange rate

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Calculating Risk- various concepts

• There are two ways of assessing risk– Behavioural view

• Sensitivity analysis• Probability distribution

– Quantitative / Statistical view • Standard deviation• Coefficient of variation• Coefficient of correlation

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Behavioural View

• Sensitivity analysis:– Assessing risk using a no of possible return estimates– Assessing variability among returns

• Worst (pessimistic)• Expected (most likely)• Best (Optimistic)

– Range = Difference b/w Optimistic & pessimistic outcomes.

– Greater the range, more is the risk and so on .– Again, the level of risk may be related with the state of

economy.

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Sensitivity analysis (Illustration)State of

EconomyParticulars Asset X Asset Y

Initial Outlay 50 50Annual return (%)

Recession Pessimistic 14 8Normal Most Likely 16 16Boom Optimistic 18 24

Range =(Optimistic – Pessimistic)

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Decision : From the investors view point the Asset Y is more risky than the Asset X, since the RANGE of ASSET Y > ASSET X.

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• Probability Distribution:– width of the probability distribution of rates of

return is the measure of risk.– The wider the probability distribution the greater

is the risk or greater is the variability of return the greater is the variance.

– The variance can be appraised visually.

Behavioural View

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IllustrationRET--A PA RET--B PB

38 0.05 90 0.123 0.2 50 0.258 0.5 20 0.3-7 0.2 -10 0.25

-22 0.05 -50 0.1

The above table is the probability distribution of the rates of return of Cos. A & B.

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-60 -40 -20 0 20 40 60 80 1000

0.1

0.2

0.3

0.4

0.5

0.6

Stock of Co.A

Stock of Co.B

Return of Stocks A & B

Prob

abili

ty o

f Sto

cks

A &

B

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Quantitative /Statistical View1>> STANDARD DEVIATION:• In case of Normal data

• Where,• Standard Deviation or Total Risk of Individual security ‘i’.

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• When Probability is given

• Where,• Standard Deviation or Total Risk of Individual

security ‘i’.

Quantitative /Statistical View

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• S.D. (σ) of a Portfolio of 2 Securities:

•

• Where,• TotalRisk of Portfolio of 2 Securities


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• S.D. of Portfolio of 3 Securities:

• Where,• TotalRisk of Portfolio of 3 Securities


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2>> COVARIANCE• In case of Normal Data:

• Where,


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• When Probability is given:

• Where,


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3>> COEFFICIENT OF CORRELATION:

•

• Where,

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Does diversification reduces risk?

UNIQUE RISK

MARKET RISK

TOTAL RISK

No. of Securities

σp

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SD of L 16 ρ ρ ρ ρ ρ

SD of H 20 1 0.5 0 -0.5 -1

Portfolio No.

Weights Average ReturnsPortfolio Return

Portfolio Risk (σp) when the correlation coefficent is

L H L H ρ= +1 ρ= 0.5 ρ=0 ρ= -0.5 ρ= -1

1100.00

% 0.00 % 12 16 12 16 16 16 16 16

2 90.00% 10.0% 12 16 12.4 16.4 15.50 14.54 13.51 12.4

3 80.00% 20.0% 12 16 12.8 16.8 15.20 13.41 11.34 8.8

4 70.0% 30.0% 12 16 13.2 17.2 15.12 12.71 9.71 5.2

5 60.0% 40.0% 12 16 13.6 17.6 15.26 12.50 8.91 1.6

6 50.0% 50.0% 12 16 14 18 15.62 12.81 9.17 2

7 40.0% 60.0% 12 16 14.4 18.4 16.18 13.60 10.40 5.6

8 30.0% 70.0% 12 16 14.8 18.8 16.92 14.80 12.32 9.2

9 20.0% 80.0% 12 16 15.2 19.2 17.82 16.32 14.66 12.8

10 10.0% 90.0% 12 16 15.6 19.6 18.85 18.07 17.26 16.4

11 0.0% 100.0% 12 16 16 20 20.00 20.00 20.00 20

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11 12 13 14 15 16 170

5

10

15

20

25

r=+1r= 0.5r= 0r= -0.5r= -1

S.D. under different degrees of Correlation

Expe

cted

Ret

urn

on P

ortf

olio

's

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Risk & Return Trade-off theory

σp

Retu

rn

Rf

Bank & PO Savings A/c

Bank & PO Certificates & Deposits

PPF A/c

RD A/c

Debentures

Bond

Preference Shares

Equity Shares

Venture Capital

Capital Structure

Dividend

Investment

Factors influencing the Risk & Return

Trade-off

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Markowitz Theory• This theory was developed by Harry Markowitz. Also known as the

Mean-Variance Model. According to him, investors are mainly; concerned with 2 properties of an asset: risk & return , but by diversification of portfolio it is possible to trade-off b/w them.

• This concept helps one to determine the feasible set of portfolios or the portfolio opportunity set or the minimum variance portfolio set. Graphically these are summarized by the minimum variance frontier of risky assets. Each point along the minimum variance frontier represents the lowest possible variance that can be attained for a given portfolio’s expected return. The point to the extreme left on the minimum-variance frontier represents the global minimum variance portfolio. Similarly, the highest point represents the global maximum return portfolio. The line segment b/w the global minimum variance portfolio and the global maximum return portfolio constitutes the Efficient Frontier.

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• Assumptions :– The rate of return from the investment is the most

important outcome. Investors conceptualize the possible rates of return from an investment as a probability distribution of rates of return either consciously or subconsciously.

– Investors are averse to risks. They seek the highest level of return for a given risk class.

– Investors estimate risk in terms of the variability of the expected returns.

– Investors base their decisions solely on two decisions parameters – expected return and variance ( or SD).

Markowitz Theory

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Efficient Frontier & its Utility• The Efficient Frontier represents the efficient portfolios

i.e., portfolios having maximum return at each level of risk (σ).

• Efficient portfolios dominate all other portfolios and individual assets, which lie below the efficient frontier.

• Dominant portfolios offer maximum return for the given level of risk or, conversely, the minimum risk for the selected rate of return.

• The Efficient frontier is convex towards the vertical axis (i.e., axis of expected return) as all assets have a correlation between +1 and -1.

• The Efficient frontier can never be concave to the vertical axis.

A B

C

D E

F

Global maximum return portfolio

Global minimum variance portfolio

Minimum variance frontier

Efficient portfolios

Dominant portfolios

Efficient FrontierE(r)

σp

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Single Index Model

• E (r)= α + βiRm + ei2

• Where,

• = alpha i.e., intercept or risk free return• It can be also explained as measure of

systematic risk.• Rm= Return of the market.

• ei2= Un-systematic risk

CAPM [Capital Asset Pricing Model]

• Model is based on the portfolio theory developed by Harry Markowitz. The model emphasizes that the risk factor in the portfolio theory is a combination of 2 risks i.e., systematic and unsystematic risks.

• The model states that a securities’ return is directly related to its systematic risk, which cannot be neutralized through diversification.

Assumptions of CAPM• Efficient capital market exists.• Investors base their portfolio investment decision on security, its expected

return and s.d. criteria.• Investors may borrow & lend without limit at risk free rate of return.• Identical expectations about future outcomes.• Market wide influences that affect all assets to some extent such as the state

of economy.• No transaction costs involved.• Capital markets are in equilibrium.• No market imperfections. Investments are infinitely divisible, information is

costless, there are no taxes or interest rate changes and there is no inflation.• Investors are risk averse & maximize expected utility of wealth.• Securities doesn’t faces any bankruptcy.

Rf

Km

SML

Risk premium

Expe

cted

/ re

quire

d ra

te o

f ret

urn

Defensive Securities

Aggressive Securities1.0 β

CAPITAL ASSET PRICING MODEL (CAPM)

Rf = Risk free rate of return

Km = Required rate of return / Return on Market portfolio

Ks = Rf + βs ( Km – Rf) Ks = Expected rate of return on security ‘s’

( Km – Rf) =

Slope of the SML

Riskβ

Retu

rn

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Concept of CML & SML

• CML• SML• How one differs from the other?

92

• CML vs. SML• CML stands for Capital Market Line, and SML stands for Security Market Line.• The CML is a line that is used to show the rates of return, which depends on risk-free rates of

return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time.

• One of the differences between CML and SML is how the risk factors are measured. While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML.

• The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio.

• While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios.

• While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis. The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML.

• Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML.

• Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks.

SMLCML

RfRf

Portfolio A

Portfolio B Portfolio CSecurity B

Security A

Security CSecurity E

Security FSecurity D

βiσi

Slope Slope

Retu

rns

Retu

rns

y=mx + c

y=mx + c

94

APT Theory• The Arbitrage Pricing theory was developed by Ross in 1976.• The APM is a multifactor model instead of just a single beta value; there is

a whole set of beta values- one for each factor. • It states that the expected return on an investment is dependent upon

how that investment reacts to a set of individual macro-economic factors ( the degree of reaction being measured by the betas) and the risk premium associated with each of those macro-economic factors.

• Ross explained that risk/ risk premium relationship of a particular security.• CAPM tell us that:

• APT tells us that:

• +

95

APT Theory

• The various factors identified by experts are:– Changes in the level of industrial production in the

economy– Changes in the shape of the yield curve– Changes in the default risk premium (i.e., changes in

the return required on bonds with different perceived risks of default).

– changes in the inflation rate– Level of personal consumption– Level of money supply in the economy.

96

Some other measures• COEFFICIENT OF VARIATION:• It is a measure of relative dispersion (risk) or a measure of risk

per unit of expected return.• It converts S.D. (σ) of expected value into relative values to

enable / comparison of risk associated with assets having different expected values.

• FORMULA of Coefficient of Variation:

• Where,• = S.D of security X.• = Mean Return of Security X.• CV= Coefficient of Variation.

97

Beta (β)• BETA:1>> Calculating β through Correlation Method

•

•

• Where , • Covim= Covariance between the returns of security ‘i’ and the market ‘m’.

• ρim=Correlation between the returns of security ‘i’ and the market ‘m’.

• σi= Standard Deviation of the returns of security ‘i’.

• σm= Standard Deviation of the returns of security ‘m’.• Δ = Change

98

2>> Calculation of through Regression Model

3>> Portfolio Beta

• Where,

Beta (β)

99

Alpha (α)1>> ALPHA (α)• CAPM Model Approach:

• Note: With the CAPM, a security's alpha is equal to the vertical distance by which it lies above or below the SML. – if i> 0 then security ‘i’s expected return is above the SML and the

security is underpriced;– if i< 0 then security ‘i’s expected return is below the SML and the

security is overpriced;– if i = 0 then security ‘i’s expected return is on the SML and the

security is correctly priced.

100

2>> Regression Coefficient Approach:

• Where,

Alpha (α)

101

3>> Portfolio Alpha:

• Where,

Alpha (α)

102

Portfolio Revision

• The term Portfolio Revision will exist if the following conditions are evident:

i. The art of changing the mix of securities in a portfolio is called as portfolio revision.

ii. The process of addition of more assets in an existing portfolio or changing the ratio of funds invested is called as portfolio revision.

iii. The sale and purchase of assets in an existing portfolio over a certain period of time to maximize returns and minimize risk is called as Portfolio revision.

103

Need for Portfolio Revision

• The self need for investment.• Change in investment goal of the investor.• Due to fluctuations in the financial markets.

104

Portfolio Revision Strategies• There are two types of Portfolio Revision Strategies.• Active revision strategies

– Active Revision Strategy involves frequent changes in an existing portfolio over a certain period of time for maximum returns and minimum risks. It helps a portfolio manager to sell and purchase securities on a regular basis for portfolio revision.

• Passive revision strategies– Passive Revision Strategy involves rare changes in portfolio

only under certain predetermined rules. These predefined rules are known as formula plans. According to this strategy a portfolio manager can bring changes in the portfolio as per the formula plans only.

105

Active Revision Management

• It is holding securities based on the forecast about the future.

• The portfolio managers vary their cash position or beta of the equity portion of the portfolio based on the market forecast.

• For e.g.- IT or FMCG industry stocks may be given more weights than their respective weights in the NSE-50.

106

Passive Revision Management

• It is a process of holding a well diversified portfolio for long term with the buy and hold approach.

• It also refers to the investor’s attempt to construct a portfolio that resembles the overall market returns.

• For e.g.- If Reliance Industry’s stock constitutes 5% of the index, the fund also invests of 5% of its money in Reliance Industry Stock.

107

Formula Plans

• The formula plans provide the basic rules and regulations for the purchase & sale of securities.

• These predetermined rules call for specified actions when there are changes in the securities market.

• In this, the investor divide his investment funds into 2 portfolios i.e. one aggressive(portfolio consists of equity shares)& other conservative or defensive ( bonds & debentures)

Basic Rules of Formula Revision

1) Formula plans require the investor to divide his investment funds in two portfolios i.e. aggressive & Conservative (defensive).

2) The volatility of aggressive portfolio must be greater than that of conservative portfolio, the larger the difference between the two, the greater the profits the formula plan can yield.

3) The conservative (defensive) portfolio must include high- grade bonds having a high degree of safety and stability of the returns.

4) The conservative portfolio tends to decline during periods of prosperity, owing to falling interest rates. While the stock prices are rising, therefore, the aggressive portfolio also rises.

5) The basic premise of formula plans is that stock and bond prices of the portfolios move in opposite direction. If they move in same direction then this phenomenon certainly impairs profitability of the formula plans.

6) The formula plans do not deal with the selection of stocks or bonds

Different types of Formula Plans

• Rupee Cost Averaging• Constant Rupee Plan• Constant Ratio Plan• Variable Ratio Plan

111

Utility of Formula Plans

• Formula plans help an investor to make the best possible use of fluctuations in the financial market. One can purchase shares when the prices are less and sell off when market prices are higher.

• With the help of Formula plans an investor can divide his funds into aggressive and defensive portfolio and easily transfer funds from one portfolio to other.

112

PORTFOLIO EVALUATION&

MUTUAL FUNDS

113

What is a Mutual Fund?

• According to SEBI regulations act 1996, “Mutual Fund means a fund established in the form of a trust to raise monies through the sale of units to the public or a selection of public under one or more schemes for investing in securities, in accordance with regulations”.

115

SBI Group/ Templetion

International Inc.

SBI MF Trustee Co. Pvt. Ltd. /

Templetion Services Pvt.

Ltd.

SBI MF / Templetion MF

SBI Funds Management Pvt. Ltd. / Templetion AMC (India) Pvt.

Ltd.

JP Morgan Chase / Deutsche Bank is the

Custodian of ABN Amro MF. In-house

Out source to SEBI who assists

them as it has its own registered

houses like Karvy, CAMS

116

How a MF is set up?• The MF is set up in the form of a trust, which has a sponsor, trustees, AMC &

custodian. The trust is established by a sponsor or more than one sponsor who is like promoter of a Co. The trustees of a MF hold its property for the benefit of the unit holders.

• Asset Management Co. (AMC) approved by SEBI manages the funds by making investments in various types of securities. Custodian, who is a registered with SEBI, holds the securities of various schemes of the fund in its custody.

• The Trustees are vested with the general power of superintendence & direction over AMC. They monitor the performance & compliance of SEBI regulations by MF.

• SEBI regulations requires that at least 2/3rds of the Directors of Trustee Co. or Board of a Trustees must be independent i.e., they should not be associated with the sponsors.

• Also, 50% of the directors of AMC must be independent. All MFs are required to be registered with SEBI before they launch any scheme.

117

Players & their functions• Sponsors

– Akin to the promoter of the Co.– Establishes the MF– Gets it registered with SEBI– Forms a Trust & appoints the Board of Trustees– Contribute at least 40% of the networth of the AMC.

• Trustees– Board of trustees hold the property of MF on behalf of the unit holders– Appointment of AMC and ensure that all the activities of the AMC are in

accordance with the SEBI regulations.– Appoint the custodian of the fund. However it must be remembered that a

sponsor cannot be appointed as a custodian if he holds 50% voting rights in the Custodian Co.

– Accountable for funds & property of the respective schemes.

118

Players & their functions• AMC

– Floatation of various MF schemes matching with the requirements of investing public.

– Management of MFs in accordance with SEBI guidelines– For carrying out asset management activities , the AMC charges fee to the

schemes it manages with the ceiling prescribed under regulations.• Custodians

– Holds the funds and securities in safe keeping.– Settles securities transactions of the fund.– Collects interests & dividends paid on securities.– Records information on stock splits and other corporate actions.

• Distributors /Agents– Sells units on behalf of the fund.– Distributors comprising of banks, NBFCs & other distribution Cos., individual

constitute the agency force.

119

Players & their Functions

• Banker– Facilitates the financial transactions – Provides remittance, facilitates

• Registrars & Transfers Agents– Maintains records of unit holders A/Cs and transaction– Receive funds from the investing public and allotted

units.– Disburses the fund to the unit holders – Handles communication with the unit holders– Provide unit holders transaction services.

121

Difference b/w MFs & ULIPsPoints of

DifferenceMutual Funds ULIPs

1. Regulations Body SEBI IRDA

2. Agents Untied agents who can still products offered by more than one company.

Tied agents attached to one particular insurer /Co.

3. Transparency Strict Transparency Less transparency

4. Flexibility Less flexible as if we opt to invest in MF and a term policy. Then the life cover cannot be increased without investing a less amount i.e., the investor has to purchase a new policy & paying a far more administration costs.

High flexible, as, if suppose an investor has a risk cover of Rs. 5 lakh & would like to increase it up to Rs.6 lakh, we can still pay the same amount of premium. The only difference would that the amount deducted towards the risk cover would be more & therefore, the amount invested would be less.

122

Points of Difference

Mutual Funds ULIPs

5. Focus of investment

Medium term Long term

6. Expenses The charges are comparatively less than that of ULIPs. FMC, Admin. Fee, Distribution Fee, Brokerage Cost, Interest Cost, Loads—Front end & Close end, Redemption / Transaction Fee, A/C Maintenance Fee.

The charges are mostly front load, i.e., most of the charges are recovered within the few years. Premium Allocation Charges, Mortality Charges, Policy Admin Charges, Surrender Charges, Fund Switching Charges.

7. Income Tax benefitsa. Investment amount

Only ELSS scheme u/s 80C is eligible for deduction.

Eligible for deduction for u/s 80C all plans. Some plans avail deduction u/s 80D also , if medical benefit rider is provided.

b. Maturity proceeds

Fully taxable. Capital Gains Tax of 10% on net proceeds If investment is made for ST , else 20% if Investment made for LT.

Exempted u/s 10(10d)

123

NAV – Net Assets Value

• As defined by AMFI – “Net asset value is the market value of the assets of the scheme minus its liabilities”. The per unit NAV is the net asset value of the scheme divided by the no. of units outstanding on the valuation date.

• NAV is calculated as follows:

124

Illustration

• The MV of a MF scheme is Rs.200 lakhs & the MF has issued 10 lakhs units of Rs.10/- each to the investors. Then calculate the NAV per unit.

• FMV = Fair Market Value = Rs.200 lakhs• No. of o/s units = 10 lakhs• NAV = • NAV

125

Some useful RATIOS for evaluating MF performance

• Sharpe’s Ratio / Sharpe’s Performance Index:– Sharpe’s performance Index gives a single value to be

used for the performance of various funds or portfolios. – Sharpe’s index measures the risk premium of the

portfolio relative to the total amount of risk in the portfolio.

– The risk premium (Rm-Rf) is the difference b/w the portfolio’s average rate of return & the riskless rate of return.

– The S.D denotes the portfolio risk– Sharpe’s Index is expressed as under:

Where, S= Sharpe’s IndexRp= Portfolio ReturnRf= Risk-free returnσp= Portfolio Risk

126

• Treynor’s performance Index / Treynor’s Ratio:– To understand the above measure one needs to understand

the concept of Characteristic line or SML.– The SML explains the relationship b/w a given market return

and the fund’s return.– The funds performance is measured in relation to the market

performance.– The whole crux lies in the fact that an ideal fund’s return rises

at a faster rate than the general market performance.– The relationship b/w the market return & fund’s return is

assumed to be linear.– The SML or Characteristic line can be drawn by plotting the

fund’s rate of return. – A steep slope indicates that the fund is very sensitive to the

market.

127

• Treynor’s Ratio/Index

𝑻=𝑹𝒑−𝑹 𝒇

𝜷𝒑

128

Market returns

Fund

retu

rns

129

• Jensen’s Alpha

– With the CAPM, a security's alpha is equal to the vertical distance by which it lies above or below the SML.

• if p> 0 then portfolio ‘p’s expected return is above the SML and the portfolio is underpriced;

• if p< 0 then portfolio ‘p’sexpected return is below the SML and the portfolio is overpriced;

• if p= 0 then portfolio ‘p’sexpected return is on the SML and the portfoliois correctly priced.

• Jensen’s Index

𝑱=𝜶𝒑

𝜷𝒑

130

• Eugene Fama’s Measure

131

• Sortino’s Ratio / Index:– This ratio was introduced be Sortino & Price in 1994.– This ratio measures the adjustment return of an investment assets or

portfolio.– The above authors were of the view that other measures like the Sharpe’s

Ratio calculates the degree of risk covered by excess return over the risk free-asset. However from the investor’s point of view Sortino assessed that there are 2 types of volatility upside and downside. On Behavioural analysis, they found out that, psychologically investors are glad to bear the upside volatility but unhappy to bear the downsided volatility.

– They devised an assessment tool to depict the true psychology of the investor towards the fund, i.e. the Sortino Ratio.

132

• Target Return = Minimum acceptable return or Risk Free rate= Rf

• Portfolio Return = Rp

• Downside Risk= Semi standard deviation, or the square root of the 2nd lower partial moment.

• Lower Sortino Ratios signify investments with a greater risk of large losses and should be avoided by risk-averse investors.

http://4.bp.blogspot.com/-fyRulfvJ4EM/TeFxCLDnkoI/AAAAAAAAA9c/uQ9QcTiE_Lk/s1600/Lower+partial+moment+downside+risk.png

133

EFFICIENT MARKET HYPOTHESIS

134

Topics to be discussed

• Efficient Market Concept.• What is Efficient Market Hypothesis all about?• Different forms of Efficient markets?• Tests of different forms.• Anomalies related to EMH Theory

Efficient Market Concept• Information is Power:

– Street professionals seek bargain stocks 24/7

– information is serious business

• Coin Flipping Contest: Investment metaphor for gambling

– short-term speculation in stocks and bonds = buying lottery tickets

– winning tips are probably wrong

Definition of Efficient Markets• An efficient capital market is a market that is efficient in

processing information.• We are talking about an “informationally efficient” market, as

opposed to a “transactionally efficient” market. In other words, we mean that the market quickly and correctly adjusts to new information.

• In an informationally efficient market, the prices of securities observed at any time are based on “correct” evaluation of all information available at that time.

• Therefore, in an efficient market, prices immediately and fully reflect available information.

Definition of Efficient Markets (cont.)

• Professor Eugene Fama, who coined the phrase “efficient markets”, defined market efficiency as follows:– "In an efficient market, competition among the many

intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."

History• Prior to the 1950’s it was generally believed that the

use of fundamental or technical approaches could “beat the market” (though technical analysis has always been seen as something akin to voodoo).

• In the 1950’s and 1960’s studies began to provide evidence against this view.

• In particular, researchers found that stock price changes (not prices themselves) followed a “random walk.”

• They also found that stock prices reacted to new information almost instantly, not gradually as had been believed.

The Efficient Markets Hypothesis

• The Efficient Markets Hypothesis (EMH) is made up of three progressively stronger forms:– Weak Form– Semi-strong Form– Strong Form

The EMH Graphically• In this diagram, the circles

represent the amount of information that each form of the EMH includes.

• Note that the weak form covers the least amount of information, and the strong form covers all information.

• Also note that each successive form includes the previous ones.

Strong Form

Semi-Strong

Weak Form

All information, public and private All public information

All historical prices and returns

The Weak Form• The weak form of the EMH says that past prices, volume, and

other market statistics provide no information that can be used to predict future prices.

• If stock price changes are random, then past prices cannot be used to forecast future prices.

• Price changes should be random because it is information that drives these changes, and information arrives randomly.

• Prices should change very quickly and to the correct level when new information arrives (see next slide).

• This form of the EMH, if correct, repudiates technical analysis.• Most research supports the notion that the markets are weak

form efficient.

Price Adjustment with New Information

At 10AM EST, the U.S. Supreme Court refused to hear an appeal from MSFT regarding its anti-trust case. The stock immediately dropped. This example, one of hundreds available every day, illustrates that prices adjust extremely rapidly to new information.

But, did the price adjust correctly? Only time will tell, but it does seem that over the next hour the market is searching for the correct level.

Notes: Each bar represents high, low, and close for one-minute. Each solid gridline represents the top of an hour, and each dotted gridline represents a half-hour.

Tests of the Weak Form

• Serial correlations / Auto Correlation Test.• Runs tests.• Filter rules.• Relative strength tests.• Many studies have been done, and nearly all

support weak form efficiency, though there have been a few anomalous results.

Serial Correlations• The following chart shows the relationship (there is none)

between S&P 500 returns each month and the returns from the previous month. Data are from Feb. 1950 to Sept. 2001.

• Note that the R2 is virtually 0 which means that knowing last month’s return does you no good in predicting this month’s return.

• Also, notice that the trend line is virtually flat (slope = 0.008207, t-statistic = 0.2029, not even close to significant)

• The correlation coefficient for this data set is 0.82%

Serial Correlations (cont.)

Unlagged vs One-month Lagged S&P 500 Returns

y = 0.008207x + 0.007451

R2 = 0.000067

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

-30.00% -20.00% -10.00% 0.00% 10.00% 20.00%

One-month Lagged Returns

Unl

agge

d R

etur

ns

The Semi-strong Form• The semi-strong form says that prices fully reflect all publicly

available information and expectations about the future.• This suggests that prices adjust very rapidly to new

information, and that old information cannot be used to earn superior returns.

• The semi-strong form, if correct, repudiates fundamental analysis.

• Most studies find that the markets are reasonably efficient in this sense, but the evidence is somewhat mixed.

Tests of the Semi-strong Form

• Event Studies– Stock splits– Earnings announcements– Analysts recommendations

• Cross-Sectional Return Prediction– Firm size– BV/MV– P/E

Analysts’ Performance

This chart from the Wall Street Journal, shows that when analysts issue sell recommendations, those stocks frequently outperform those with buy or hold ratings. If the professionals can’t get it right, who can?

Mutual Fund Performance• Generally, most academic studies have found that mutual

funds do not consistently outperform their benchmarks, especially after adjusting for risk and fees.

• Even choosing only past best performing funds (say, 5-star funds by Morningstar) is of little help. A study by Blake and Morey finds that 5-star funds don’t significantly outperform 3- and 4-star funds over time.

• However, it does seem that you can “weed out” the bad funds (1- and 2-stars). Funds that have performed badly in the past seem to continually perform badly in the future.

The Strong Form

• The strong form says that prices fully reflect all information, whether publicly available or not.

• Even the knowledge of material, non-public information cannot be used to earn superior results.

• Most studies have found that the markets are not efficient in this sense.

Tests of the Strong Form

• Corporate Insiders.• Specialists.• Mutual Funds.• Studies have shown that insiders and specialists

often earn excessive profits, but mutual funds (and other professionally managed funds) do not.

• In fact, in most years, around 85% of all mutual funds underperform the market.

Anomalies

• Anomalies are unexplained empirical results that contradict the EMH:– The Size effect.– The “Incredible” January Effect.– P/E Effect.– Day of the Week (Monday Effect).

The Size Effect

• Beginning in the early 1980’s a number of studies found that the stocks of small firms typically outperform (on a risk-adjusted basis) the stocks of large firms.

• This is even true among the large-capitalization stocks within the S&P 500. The smaller (but still large) stocks tend to outperform the really large ones.

The “Incredible” January Effect

• Stock returns appear to be higher in January than in other months of the year.

• This may be related to the size effect since it is mostly small firms that outperform in January.

• It may also be related to end of year tax selling.

The P/E Effect

• It has been found that portfolios of “low P/E” stocks generally outperform portfolios of “high P/E” stocks.

• This may be related to the size effect since there is a high correlation between the stock price and the P/E.

• It may be that buying low P/E stocks is essentially the same as buying small company stocks.

The Day of the Week Effect

• Based on daily stock prices from 1963 to 1985 Keim found that returns are higher on Fridays and lower on Mondays than should be expected.

• This is partly due to the fact that Monday returns actually reflect the entire Friday close to Monday close time period (weekend plus Monday), rather than just one day.

• Moreover, after the stock market crash in 1987, this effect disappeared completely and Monday became the best performing day of the week between 1989 and 1998.

Summary of Tests of the EMH • Weak form is supported, so technical analysis cannot

consistently outperform the market.• Semi-strong form is mostly supported , so fundamental

analysis cannot consistently outperform the market.• Strong form is generally not supported. If you have secret

(“insider”) information, you CAN use it to earn excess returns on a consistent basis.

• Ultimately, most believe that the market is very efficient, though not perfectly efficient. It is unlikely that any system of analysis could consistently and significantly beat the market (adjusted for costs and risk) over the long run.

158

Equity Analysis & Valuation

159

FUNDAMENTAL ANALYSIS

Three vital steps of Fundamental Analysis

• Macroeconomic analysis: evaluates current economic environment and its effect on industry and company fundamentals

• Industry analysis: evaluates outlook for particular industries

• Company analysis: evaluates company’s strengths and weaknesses within industry

Macroeconomic Analysis

• Business Cycles– Expansion, Peak, Contraction, Trough– Impact of Inventory and Final Sales

• Economic Indicators (see Table 7-2 on page 7.7)– Leading (10): new orders, building permits, first time

unemployment claims, stock prices, rate spreads– Coincident (4): Non-ag payroll, industrial production– Lagging (7): Inventory-to-sales, labor cost

Fiscal & Monetary Policy

• Fiscal Policy (Keynesians)– Government expenditures (demand)– Tax & Debt policies

• Monetary Policy (Monetarists – M. Friedman)– Interest rates (discount, fed funds)– Money supply (Open market ops): M1, M2– Reserve requirements (commercial banks)– Margin requirements (brokerage accounts)

Goals of Policy

• Full Employment– Interest Rates– Money Supply

• Price Stability (control inflation)– Interest Rates– Money Supply

• Economic Growth– Interest Rates– Money Supply

Impediments to Effective Policy

• Time lags between [stimulus] and [desired effect]

• Unintended consequences– “irrational” expectations on part of policy makers– Adverse influence of speculators– Adverse global responses

• Consumer behavior (rational expectations)• Incorrect analysis, actions, or timing by policy

makers

Industry Analysis

• Classifying industries– Cyclical industry - performance is positively related

to economic activity– Defensive industry - performance is insensitive to

economic activity– Growth industry - characterized by rapid growth in

sales, independent of the business cycle

Industry Analysis

• Industry Life Cycle Theory: – Birth (heavy R&D, large losses - low revenues)– Growth (building market share and economies of

scale)– Mature growth (maximum profitability)– Stabilization (increase in unit sales may be

achieved by decreasing prices) – Decline (demand shifts lead to declining sales and

profitability - losses)

Industry Analysis

• Life Cycle of an Industry (Marketing view)– Start-up stage: many new firms; grows rapidly

(example: genetic engineering)– Consolidation stage: shakeout period; growth

slows (example: video games)– Maturity stage: grows with economy (example:

automobile industry)– Decline stage: grows slower than economy

(example: railroads)

Industry Analysis

• Qualitative Issues– Competitive Structure– Permanence (probability of product obsolescence)– Vulnerability to external shocks (foreign

competition)– Regulatory and tax conditions (adverse changes)– Labor conditions (unionization)

Industry Analysis

• End use analysis – identify demand for industry’s products– estimates of future demand– identification of substitutes

• Ratio analysis– examining data over time – identifying favorable/unfavorable trends

• Regression analysis – determining the relationship between variables

Company Analysis: Qualitative Issues

• Sales Revenue (growth)• Profitability (trend)• Product line (turnover, age)

– Output rate of new products– Product innovation strategies– R&D budgets

• Pricing Strategy• Patents and technology


• Organizational performance– Effective application of company resources– Efficient accomplishment of company goals

• Management functions– Planning - setting goals/resources– Organizing - assigning tasks/resources– Leading - motivating achievement– Controlling - monitoring performance


• Evaluating Management Quality– Age and experience of management– Strategic planning

• Understanding of the global environment• Adaptability to external changes

– Marketing strategy• Track record of the competitive position• Sustainable growth• Public image

– Finance Strategy - adequate and appropriate– Employee/union relations– Effectiveness of board of directors

Company Analysis: Quantitative Issues

• Operating efficiency– Productivity– Production function

• Importance of Q.A.– Understanding a company’s risks

• Financial, operating, and business risks• Financial Ratio Analysis

– Past financial ratios – With industry, competitors, and

• Regression analysis– Forecast Revenues, Expenses, Net Income– Forecast Assets, Liabilities, External Capital Requirements

“Financial statements are like fine perfume;To be sniffed but not swallowed.”


• Balance Sheet– Snapshot of company’s Assets, Liabilities and Equity.

• Income statement– Sales, expenses, and taxes incurred to operate– Earnings per share

• Cash flow statement– Sources and Uses of funds

• Are financial statements reliable?– G.A.A.P. vs Cleverly Rigged Accounting Ploys


• Financial Ratio Analysis– Liquidity (ability to pay bills)– Debt (financial leverage)– Profitability (cost controls)– Efficiency (asset management)

• DuPont Analysis– Top-down analysis of company operations– Objective: increase ROE

Liquidity Ratios

• Measure ability to pay maturing obligations• Current ratio

– Current assets / current liabilities• Quick ratio

– (Current assets less inventories) / current liabilities

Debt Ratios

• Measure extent to which firm uses debt to finance asset investment (risk attribute)

• Debt-equity ratio– Total long-term debt / total equity

• Total debt - total assets ratio– (Current liabilities + long-term debt) / total assets

• Times interest earned– EBIT / interest charges

• Fixed charge coverage ratio– (EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.)

Profitability Ratios

• Measure profits relative to sales• Gross profit margin ( % ) = Gross profit / sales• Operating Profit Margin = Operating profits /

sales• Net profit margin = Net profit after taxes / sales• ROA = Net Profit / Total Assets• ROE = Net Profit / Stockholder Equity*

* Excludes preferred stock balances

Efficiency Ratios

• Measure effectiveness of asset management• Average collection period (in days)

– Average receivables / Sales per day• Inventory turnover (times per year)

– Cost of Goods Sold / average inventory• Total asset turnover

– Sales / average total assets• Fixed asset turnover

– Sales / average net fixed assets

Other Ratios

• Earnings per share (EPS): (Net income after taxes – preferred dividends)/ number of shares

• Price-earnings (P/E): Price per share/expected EPS• Dividend yield: Indicated annual dividend/price per share• Dividend payout: Dividends per share/EPS• Cash flow per share: (After-tax profits + depreciation and

other noncash expenses)/number of shares• Book value per share: Net worth attributable to common

shareholders/number of shares

DuPont Analysis of ROE

equity Common

profitsNet

equity rs'stockholde Common

safter taxe profitsNet ROE

3 Ratio

Equity

Assets Total

2 Ratio

Assets Total

Sales

1 Ratio

Sales

sNet Profit

Equity

sNet ProfitROE

Ratio 1 = NPM Ratio 2 = TATO Ratio 3 = Equity Kicker

The DuPont System suggests that ROE (which drives stock price) is a functionof cost control, asset management, and debt management.

Estimating Earnings and Fair Market Value for Equity

• Five Steps1. Estimate next year’s sales revenues2. Estimate next year’s expenses3. Earnings = Revenue - Expenses4. Estimate next year’s dividend per share

• = Earnings Per Share * dividend payout ratio

5. Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends.

• Using Gordon Growth model or P/E Model

Woerheide’s Conclusions

• Fundamental Analysis vs. Market Efficiency– Fundamental analysis critical when dealing with

private companies– Necessary condition for market efficiency of

publicly traded companies (although worthless at the margin)

– Earnings surprises major component of performance

• How much is real?• How much is C. R. A. P.?

185

TECHNICAL ANALYSIS

• Technical analysis is the study of historical prices for the purpose of predicting prices in the future

• Technical analysts frequently utilize charts of past prices to identify historical price patterns

• These price patterns are then used to forecast prices in the future• A basic belief of technical analysts is that market prices themselves

contain useful and timely information – Prices quickly reflect all available fundamental information, as well as

other information, such as traders’ expectations and the psychology of the market

Role of Technical Analysis• Identify and predict changes in direction of price trends• Determine the timing of action – entry and exit decisions

Technical Analysis:

Chart Analysis - the basic tool of technical analysis• A price chart is a sequence of prices plotted over a specific time frame.

In statistical terms, charts are referred to as time series plots• Chart analysts plots historical prices in a two-dimensional graph in

order to identify price patterns which can then be used to predict the futures direction of prices– The goal of any chart analyst is to find consistent, reliable, and logical

price patterns with which to predict future price movements

• Chart analysts rely primarily on three bodies of data– Prices (monthly, weekly, daily, and intra-day)– Trading volumes, and– Open interest

Technical Analysis: Chart Analysis

Price Pattern Recognition Charts

Technical Analysis: Chart Analysis

The most commonly used price pattern recognition charts are: bar charts, line charts, candlestick charts, and point-and-figure charts

On these charts, the Y-axis (vertical axis) represents the price scale and the X-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the X-axis with the most recent plot being the furthest right.

Bar Charts: Bar charts mark trading activity of a specified trading period (e.g.,

day) by a single vertical line on the graph This line connects the high and low prices for the trading period The closing price is indicated by a horizontal bar

Technical Analysis: Chart Analysis – Bar Chart

Technical Analysis: Chart Analysis – Bar Chart

Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar.

Technical Analysis: Chart Analysis – Bar Charts

Bar Charts: One-Day Price Reversals Bar charts are frequently used to identify one-day price reversals. A one-day price reversal occurs in a rising market when prices make

a new high for the current advance but then close lower than the previous day’s close

A one-day price reversal occurs in a falling market when prices make a new low for the current decline but then close higher than the previous day’s close

Technical Analysis: Chart Analysis – Line Charts

Line Charts: In a line chart, only the

closing prices are plotted for each time period.

Some investors and traders consider the closing level to be more important than the open, high or low.

By paying attention to only the close, intraday swings can be ignored.

Technical Analysis: Chart Analysis – Candlestick Charts

Candlestick Charts: Originating in Japan over 300 years ago, candlestick charts have

become quite popular in recent years. For a candlestick chart, the open, high, low and close are all required. Hollow (clear) candlesticks form when the close is higher than the

open and Filled (solid) candlesticks form when the close is lower than the open.

The white and black portion formed from the open and close is called the body (white body or black body). The lines above and below are called shadows and represent the high and low.

A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range and Friday's close.


Common Shapes of Candles


Bulls vs. Bears• A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given

period of time.

1. Long white candlesticks indicate that the Bulls controlled trading for most of the period – buying pressure.

2. Long black candlesticks indicate that the Bears controlled trading for most of the period – selling pressure.

3. Small candlesticks indicate that neither the bulls nor the bears were in control of trading – consolidation.

4. A long lower shadow indicates that the Bears controlled trading for some time, but lost control by the end and the Bulls made an impressive comeback.

5. A long upper shadow indicates that the Bulls controlled trading for some time, but lost control by the end and the Bears made an impressive comeback.

6. A long upper and lower shadow indicates that both the Bears and Bulls had their moments during the trading period, but neither could put the other away, resulting in a standoff.


Hollow vs. Filled Candlesticks Hollow candlesticks, where the close is higher than the open, indicate

buying pressure. Filled candlesticks, where the close is lower than the open, indicate

selling pressure.

Long vs. Short Bodies Generally speaking, the longer the body is, the more intense the

buying or selling pressure. Long white candlesticks show strong buying pressure – buyers are aggressive. Long black candlesticks show strong selling pressure – sellers are aggressive.

Conversely, short candlesticks indicate little price movement and represent consolidation.

White vs. Black Marubozus• Even more potent long candlesticks are the

Marubozu brothers, Black and White. • Marubozu do not have upper or lower shadows

and the high and low are represented by the open or close.

• A White Marubozu forms when the open equals the low and the close equals the high. – This indicates that buyers controlled the price

action from the first trade to the last trade.

• A black Marubozu forms when the open equals the high and the close equals the low. – This indicates that sellers controlled the price action

from the first trade to the last trade.


Long vs. Short Shadows• Candlesticks with short shadows indicate that most of the

trading action was confined near the open and close. • Candlestick with long shadows show that trades extended

well past the open and close• Candlesticks with a long upper shadow and short lower

shadow indicate that buyers dominated during the session, and bid prices higher. However, sellers later forced prices down from their highs, and the weak close created a long upper shadow.

• Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.


Doji• Doji form when a security's open and close are virtually

equal. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. Alone, doji are neutral patterns.

• Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level. The result is a standoff. Neither bulls nor bears were able to gain control and a turning point could be developing.

• Doji indicate that the forces of supply and demand are becoming more evenly matched and a change in trend may be near. Doji alone are not enough to mark a reversal and further confirmation may be warranted. The relevance of a doji depends on the preceding trend or preceding candlesticks.


Doji and Trend• After an advance or long white candlestick, a doji

signals that buying pressure may be diminishing and the uptrend could be nearing an end. However, even after the doji forms, further downside is required for bearish confirmation. This may come as a decline below the long white candlestick's open.

• After a decline or long black candlestick, a doji indicates that selling pressure may be diminishing and the downtrend could be nearing an end. However, further strength is required to confirm any reversal. Bullish confirmation could come as an advance above the long black candlestick's open.


Long Shadow Reversal• There are two pairs of single candlestick reversal patterns

made up of a small real body, one long shadow and one short or non-existent shadow. Generally, the long shadow should be at least twice the length of the real body, which can be either black or white.

• Hammer and Hanging Man: consists of identical candlesticks with small bodies and long lower shadows. – The Hammer is a bullish reversal pattern that forms

after a decline. A Hammer signals a potential trend reversal - that buying pressure is starting to increase. In addition, hammers can mark bottoms or support levels.

– The Hanging Man is a bearish reversal pattern that forms after an advance. Hanging Man signals that selling pressure is starting to increase. It can also mark a top or resistance level.


Inverted Hammer and Shooting Star• The Inverted Hammer and Shooting Star look exactly alike,

but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.

• The inverted hammer is a bullish reversal pattern that forms after a decline or downtrend. In addition to a potential trend reversal, inverted hammers can mark bottoms or support levels.

• The shooting star is a bearish reversal pattern that forms after an advance. A shooting star signals that selling pressure is starting to increase. It can also mark a top or resistance level.


Technical Analysis: Chart Analysis – Point-and-Figure Charts

Point-and-Figure Charts: Point-and-figure charts are constructed by filling in boxes with either a

X or an O. A price increase or decrease is defined as a price change that exceeds a

specified magnitude – a price change less than that magnitude does not receive an X or O in the chart

If prices are rising, the appropriate Xs are entered in a particular column. When prices begin to decline, a new column is started, and Os are entered in that column Each price reversal results in the start of a new column

Point-and-figure Charts are based solely on price movement, and do not take time into consideration. There is an x-axis but it does not extend evenly across the chart.


Point-and-Figure Charts: The objective of point-and-figure chart is to provide a smoothing

effect on the price changes that appear in a bar chart in order to detect significant price trends and reversals.

Point-and figure charts can also be used to generate buy and sell signals.

A buy signal occurs when an X in a new column surpasses the highest X in the immediately preceding X column.

A sell signal occurs when an O in a new column is below the lowest O in the immediately preceding O column.

This focus on price movement makes it easier to identify support and resistance levels, bullish breakouts and bearish breakdowns.

• Chart analysis uses both trend lines and geometric formations to predict market tops and bottoms, as well as future price movements

• The most popular technical price patterns are – Support and Resistance,– Trend lines,– Double tops and bottoms, and – Head-and-shoulder.

• Support and Resistance– A support level is a price level at which there appears to be substantial buying

pressure to keep prices from falling further– A resistance level is a price level at which there appears to be substantial selling

pressure to keep prices from rising further– A congestion area occurs when prices move sideways, fluctuating up and down

within a well defined range for a considerable time period

Technical Analysis: Common Technical Price Patterns

• A support level is a price level at which there appears to be substantial buying pressure to keep prices from falling further– As the price declines towards support and gets cheaper, buyers become more

inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

– Support can be established with the previous reaction lows.

• A resistance level is a price level at which there appears to be substantial selling pressure to keep prices from rising further– As the price advances towards resistance, sellers become more inclined to sell and

buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

– Resistance can be established with the previous reaction highs.

Technical Analysis: Support and Resistance

Technical Analysis: Common Technical Price Patterns

• Another principle of technical analysis is that support can turn into resistance and visa versa.

• Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.

• The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.


– A congestion area occurs when prices move sideways, fluctuating up and down within a well defined range for a considerable time period

• A congestion area signals that the forces of supply and demand are evenly balanced. – When the price breaks out of the congestion area , above or below, it

signals that a winner has emerged - A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

– When the price breaks out of the congestion area by penetrating the support it is a signal to sell.

– When the price breaks out of the congestion area by penetrating resistance it is a signal to buy.

Technical Analysis: Congestion Area – Trading Range

Technical Analysis: Congestion Area – Trading Range

• Because technical analysis is not an exact science, it is sometimes useful to create support and resistance zones.

• Sometimes, exact support and resistance levels are best, and, sometimes, zones work better.

• Generally, the tighter the range, the more exact the level. • If the trading range spans less than 2 months and the price range is

relatively tight, then more exact support and resistance levels are best suited.

• If a trading range spans many months and the price range is relatively large, then it is best to use support and resistance zones.

• These are only meant as general guidelines, and each trading range should be judged on its own merits.

Technical Analysis: Support and Resistance Zones

Technical Analysis: Support and Resistance Zones

• Identification of key support and resistance levels is an essential ingredient to successful technical analysis.

• Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities.

• If a futures contract is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal.

• If a futures contract is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed.

• A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.


• Technical analysis is built on the assumption that prices trend.

• A common trading strategy is to identify a price trend and then go with the trend.

• A trend line is a straight line that connects periodic highs or lows on a price chart and then extends into the future to act as a line of resistance or support.

• Two common types of trend lines– Uptrend lines– Downtrend lines

Technical Analysis: Trend Lines

• An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. – Uptrend lines act as support and indicate that net-demand (demand less

supply) is increasing even as the price rises. – A rising price combined with increasing demand is very bullish, and

shows a strong determination on the part of the buyers. – As long as prices remain above the trend line, the uptrend is considered

solid and intact. – A break below the uptrend line indicates that net-demand has weakened

and a change in trend could be imminent.

• When price falls below the uptrend line, this is a signal to sell or go short.

Technical Analysis: Uptrend Lines

Technical Analysis: Uptrend Line

• A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. – Downtrend lines act as resistance, and indicate that net supply (supply

less demand) is increasing even as the price declines. – A declining price combined with increasing supply is very bearish, and

shows the strong resolve of the sellers. – As long as prices remain below the downtrend line, the downtrend is

solid and intact. – A break above the downtrend line indicates that net-supply is decreasing

and that a change of trend could be imminent.

• When price breaks above the downtrend line, this is a signal to buy or go long.

Technical Analysis: Downtrend Lines

Technical Analysis: Downtrend Line

• The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.

• It can sometimes be difficult to find more than 2 points from which to construct a trend line.

• Even though trend lines are an important aspect of technical analysis, it is not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best not to force the issue.

• Trend lines can offer great insight, but if used improperly, they can also produce false signals

• Trend lines should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent.

Technical Analysis: Trend Lines - Conclusions

• Double tops or bottoms are frequently used to identify a price reversal.• In an uptrend, the failure of prices to exceed a previous price peak on

two occasions is considered a double top.– This is a warning signal that the uptrend may be about to end and a

downtrend to commence– However, the formation of a double top is not considered confirmed until

falling prices penetrate the previous low from the above.

• A double bottom is just the mirror image of a double top. • In a downtrend, the failure of prices to penetrate previous support

levels on two occasions is considered a double bottom.– This is a warning signal that the downtrend may be about to end and an

uptrend to commence

Technical Analysis: Double Tops or Bottoms

Technical Analysis: Double Tops

• Prior Trend: In the case of the double top, a significant uptrend should be in place. • First Peak: The first peak should mark the highest point of the current trend. • Trough: After the first peak, a decline takes place that typically ranges from 10 to 20%. • Second Peak: The advance off the lows usually occurs with low volume and meets

resistance from the previous high. Resistance from the previous high should be expected. Usually a peak within 3% of the previous high is adequate.

• Decline from Peak: The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two.

• Support Break: Breaking support from the lowest point between the peaks completes the double top. This too should occur with an increase in volume and/or an accelerated descent.

• Support Turned Resistance: Broken support becomes potential resistance and there is sometimes a test of this newfound resistance level with a reaction rally. Such a test can offer a second chance to exit a position or initiate a short.

• Price Target: The distance from support break to peak can be subtracted from the support break for a price target. This would infer that the bigger the formation is, the larger the potential decline.

Technical Analysis: Double Tops

http://stockcharts.com/school/doku.php?id=chart_school:glossary_r

Technical Analysis: Double Bottoms

• Prior Trend: In the case of the double bottom, a significant downtrend should be in place.• First Trough: The first trough should mark the lowest point of the current trend. • Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%. • Second Trough: The decline off the reaction high usually occurs with low volume and meets

support from the previous low. Support from the previous low should be expected. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid.

• Advance from Trough: Volume is more important for the double bottom than the double top. There should be clear evidence that volume and buying pressure are accelerating during the advance off of the second trough.

• Resistance Break: Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/or an accelerated ascent.

• Resistance Turned Support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the first correction. Such a test can offer a second chance to close a short position or initiate a long.

• Price Target: The distance from the resistance breakout to trough lows can be added on top of the resistance break to estimate a target. This would imply that the bigger the formation is, the larger the potential advance.

Technical Analysis: Double Bottoms

http://stockcharts.com/school/doku.php?id=chart_school:glossary_s

• 60-70% reliable• Frequently seen in grains and livestock commodities• On 2 consecutive days or across several weeks

Technical Analysis: Double Tops and Bottoms

• Head-and-Shoulders formations are among the most frequently used technical patterns for identifying a price reversal.

• Head-and-Shoulders formations consist of four phases:– The left shoulder– The head– The right shoulder – The penetration of the neckline

• A head-and-shoulder reversal pattern is complete only when the neckline is penetrated, either in an upward or downward direction. – Head-and-Shoulder top: The formation is complete when price penetrate the

neckline from above indicating a reversal from a uptrend to a downtrend. – Head-and-Shoulder bottom: The formation is complete when price penetrate the

neckline from below indicating a reversal from a downtrend to an uptrend.

Technical Analysis: Head-and-Shoulders Tops or Bottoms

Technical Analysis: Head-and-Shoulders Top

• Prior Trend: Without a prior uptrend, there cannot be a Head and Shoulders reversal pattern.• Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point

of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trend line, keeping the uptrend intact.

• Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.

• Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.

• Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal.

Technical Analysis: Head-and-Shoulders Tops

• Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume and the new high of the head, together, serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder.

• Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.

• Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.

• Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements, or long-term moving averages.

Technical Analysis: Head-and-Shoulders Tops

Technical Analysis: Head-and-Shoulders Bottom

• Prior Trend: Without a prior downtrend, there cannot be a Head and Shoulders Bottom formation.

• Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder (1).

• Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2).

• Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left shoulder. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete.

• Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal.

Technical Analysis: Head-and-Shoulders Bottoms

http://stockcharts.com/school/doku.php?id=chart_school:glossary_s

• Volume: While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. – Volume on the decline of the left shoulder is usually pretty heavy and selling pressure

quite intense.– The advance from the low of the head should show an increase in volume

• Neckline Break: The Head and Shoulders Bottom pattern is not complete, and the downtrend is not reversed until neckline resistance is broken. For a Head and Shoulders Bottom, this must occur in a convincing manner, with an expansion of volume.

• Resistance Turned Support: Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break, and offer a second chance to buy.

• Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered, as well.

Technical Analysis: Head-and-Shoulders Bottoms

• 70-80% reliable in terms of significant move after neckline is broken• Time required to complete can be days or up to several weeks• Frequently seen in grains and livestock commodities• Easy to recognize• Low trading volume on each side of the “head” confirms the formation

Technical Analysis: Head-and-Shoulders Tops or Bottoms

• Market trend analyses use more complex price charts as well as volume and open interest figures to determine both the existence of price trends and the strength of these trends.– Moving Averages– Rate of Change Indicators: Momentum and Oscillator– Volume and Open Interest

Market Trend Analyses:

• Moving averages are used to determine price trends and trend changes• A moving average is a statistical technique for smoothing price

movements in order to identify trends more easily.• A simple n-day moving average is the average of the most recent n

daily closing prices– A 5-day moving average is the average of the last 5 daily closing prices. – A 25-day moving average is the average of the last 25 daily closing prices.

• The number of days used to compute the average determines the sensitivity of the average to new price movements– The more days that are used, the less sensitive is the average

• Weighted moving averages can also be constructed– If greater weights are given to more recent prices, the average becomes

more sensitive to price change

Market Trend Analyses: Moving Averages

Market Trend Analyses: Simple Moving Averages (SMA)

Daily 5-Day 10-DayDay Close SMA SMA

1 60.332 59.443 59.384 59.385 59.22 59.556 58.88 59.267 59.55 59.288 59.50 59.319 58.66 59.16

10 59.05 59.13 59.3411 57.15 58.78 59.0212 57.32 58.34 58.8113 57.65 57.97 58.6414 56.14 57.46 58.3115 55.31 56.71 57.9216 55.86 56.46 57.6217 54.92 55.98 57.1618 53.74 55.19 56.5819 54.80 54.93 56.1920 54.86 54.84 55.78

Market Trend Analyses: Simple Moving Averages (SMA)

• Sometimes traders use two moving averages to determine buy and sell decisions.

• Using a slow moving average (more days) together with a fast moving average (fewer days) generates the following trading strategies:– Buy when the faster moving average goes above (crosses) the slower one

(from below). Sell when the faster moving average goes below (crosses) the slower one (from above).

– Buy when prices are above both the fast and slow moving averages. Sell when prices are below both the fast and slow moving averages.

• As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.

Market Trend Analyses: Moving Averages: Trading strategy

• Rate of change indicators, such as momentum and oscillator indices, are used as leading indicators of price changes.

• Rate of Change (ROC):

• Momentum and Oscillator are based on price changes rather than price levels, and are used to determine when a price trend is weakening or strengthening, or losing or gaining momentum.

• Momentum Index: A momentum index measures the acceleration or deceleration of a price advance or decline by using absolute price movements over a fixed time interval.

• Oscillator Index: An oscillator index is a normalized form of a momentum index.

Market Trend Analyses: Rate of Change Indicators: Momentum and Oscillator

100'

agoperiodsnChange

agoperiodsnChangechangesTodayROC

• The Relative Strength Index (RSI) is an extremely useful and popular momentum oscillator - Developed by J. Welles Wilder (1978).

• The RSI compares the magnitude of a stock's or future’s recent gains to the magnitude of its recent losses and turns that information into a number that ranges from 0 to 100. It takes a single parameter, the number of time periods (standard 14 days) to use in the calculation.

• RSI = 100 – 100/(1+RS)– RS = Average Gain / Average Loss– First Average Gain = Total of gains during the first 14 periods / 14– Average Gain = [previous average gain ×13 + Current Gain] / 14– First Average Loss = Total of losses during the first 14 periods / 14– Average Loss = [previous average loss ×13 + Current Loss] / 14– Losses are also reported as positive values

Market Trend Analyses: Relative Strength Index (RSI)

Price Avg. Avg.Days Change Gain Loss Gain Loss RSI

1 0.5 0.52 0.2 0.23 -0.3 0.34 0.6 0.65 0.2 0.26 -0.7 0.77 -0.5 0.58 -1.1 1.19 -0.2 0.2

10 0.3 0.311 0.7 0.712 0.2 0.213 -0.3 0.314 -0.4 0.4 0.19 0.25 43.5515 -0.5 0.5 0.18 0.27 40.0716 0.1 0.1 0.17 0.25 41.0817 0.3 0.3 0.18 0.23 44.1418 -0.2 0.2 0.17 0.23 42.5519 0.5 0.5 0.19 0.21 47.6120 -0.3 0.3 0.18 0.22 45.05

• Wilder recommended using 70 and 30 as overbought and oversold levels respectively. – RSI ≥ 70 => Market is overbought – Don’t buy (long)– RSI ≤ 30 => Market is oversold – Don’t sell (short)

• Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal.

• The centerline for RSI is 50. A reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning the battle.

• Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.


• Technical analysts believe that volume and open interest provide information about whether a price move is strong or weak.– If prices are rising and open interest and volume are increasing – new

money is thought to be flowing in the market, reflecting aggressive new buying – Bullish

– If prices are rising but volume and open interest are declining – the rally is thought to be caused primarily by short covering – money is leaving rather than entering the market – the uptrend will probably end once the short covering is complete – Bearish.

– If prices are falling but volume and open interest are rising – new money is thought to be flowing in the market – reflecting aggressive new short selling – the downtrend will probably continue – Bearish

– If prices are falling and volume and open interest are declining – the price decline is considered to be the result of losing longs liquidating their positions - weak downtrend – the downtrend will probably end soon – Bullish

Market Trend Analyses: Volume and Open Interest

248

Fixed Income Securities&

Valuation

Special Reference to Bonds

249

What is a Bond

• A bond is a debt instrument or a loan, typically made by investors to a corporation or government or semi-govt. or financial institutions.

• The indenture spells out the terms of the loan/debt:– Coupon– Maturity– Principal – Ownership

• A corporation can deduct the interest payments on bonds (dividends paid on stock are not deductible).

250

Characteristics of Bond Prices

• The cash flows on a bond are constant (“fixed income”).

• Face value Rs. 1000/-; 5000/-; 10,000/-• A bond’s market price changes in response to the

market interest rate.– When market rates increase, the fixed payments from

the bond are worth less so the price falls.– If rates decrease, the fixed payments are now worth

more.

[A bond’s price also changes in response to changes in the risk of the cash flows, but we are not quite ready for that discussion.]

251

DEBENTURE vs. BONDDebenture Bond

1. They can be converted into equity or other instruments.

1. They cannot be converted into other instruments.

2. They are redeemed in installments. 2. They are redeemed in lump sum.

3. Instruments issued by other entities are called debentures.

3. Long-term debt securities issued by the Government of India or any of the State Government’s or undertakings owned by them or by development financial institutions are called as bonds.

4. A debenture transfer has to be effected through a transfer form prescribed under Cos. Act 1956.

4. A bond is transferable by endorsement & delivered without payment of any transfer stamp duty.

252

Debenture Bond

5. Debenture stamp duty is a state subject and the duty varies from state to state. There are two kinds of stamp duties levied on debentures viz issuance and transfer. Issuance stamp duty is paid in the state where the principal mortgage deed is registered. Over the years, issuance stamp duties have been coming down. Stamp duty on transfer is paid to the state in which the registered office of the company is located. Transfer stamp duty remains high in many states and is probably the biggest deterrent for trading in debentures in physical segment, resulting in lack of liquidity. On issuance, stamp duty is linked to mortgage creation, wherever applicable while on transfer, it is levied in accordance with the laws of the state in which the registered office of the company in question is located. A debenture transfer, has to be effected through a transfer form prescribed for under Companies Act. 1956

5. The issuance of Stamp duty on bonds is under Indian Stamp Duty Act 1899.

DEBENTURE vs. BOND

253

Basics of Bond Valuation

• The bond pricing equation consists of two components– PV of Coupons– PV of Face Value

• The price of a bond (these PVs) depends on:– Discount Rate or YTM (r)– Number of Periods (N)– Size of Cash Flows (C and PN)

NN

NNN

N

nn r

P

rr

C

r

P

r

CB

)1()1(

11

)1()1(10

254

Yield to Maturity

• The yield to maturity is an important number in bond valuation.

• It is the rate which equates the market price of the bond with the value of the discounted cash flows.

• That is, YTM is the r such that the bond equation holds.• Finding the YTM requires a financial calculator, a goal-seeking

solver, or trial and error.

255

YTM and the Coupon Rate

• Relationship between YTM and Coupon Rate– YTM = Coupon bond is selling at par (P0 = PN).

– YTM > Coupon bond is at a discount (P0 < PN).

– YTM < Coupon bond is at a premium (P0 > PN).

• Why does the YTM differ from the coupon?– The coupon is set when the bond is issued.– The YTM is the market’s required interest rate. It

may change as economic fundamentals shift.

256

– C= Coupon– FV= Face Value– r= YTM– PV= Calculated Market Price

– r=YTM– C= Coupon– P=Premium– D=Discount– P0= PV of the Bond i.e., Current Market Price.– F=Face value of the bond.

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Point to NOTE

• In this method we can calculate YTM but through TRIAL & ERROR Method. However there is a DIRECT Formula to calculate YTM.

• If nothing is mentioned in the problem we should remember that we should use DIRECT formula to calculate YTM.

• If current MP < NPV or P0 i.e., the calculated MP of the bond, then the bond is UNDERPRICED. Again , if current MP > NPV or P0 i.e., the calculated MP of the bond , then the bond is OVERPRICED.

258

Remembering the YTM-Coupon Relationship

• Zero Coupon Bonds– Pays no coupon so interest comes in the form of a

discount from the repayment (P0 < PN).– Since Coupon = 0, YTM must be greater than Coupon.– Putting these pieces together gives the answer.

• Capital Gains– If the YTM is greater than the Coupon, the extra

return must be coming from somewhere.– The extra return comes from capital gains (P0 < PN).

259

Example - Annual Coupon

• Rs. 1000 10 year bond paying a 10% annual coupon

– What is the value when the interest rate is 10%?

– If r = 11%?

– If r = 9%?

00.1000)10.1(

1000

)10.1(

11

10.

10010100

B

11.941)11.1(

1000

)11.1(

11

11.

10010100

B

18.1064)09.1(

1000

)09.1(

11

09.

10010100

B

260

Example - Semiannual Coupon

• Now the coupon is split semiannually

– At 10%

– At 11%

– At 9%

00.1000)05.1(

1000

)05.1(

11

05.

5020200

B

25.940)055.1(

1000

)055.1(

11

055.

5020200

B

04.1065)045.1(

1000

)045.1(

11

045.

5020200

B

261

Example - Solving for YTM

• Consider a £1000 5 year bond with a 8% coupon– What is the YTM if it is selling for £1000?

– If it is selling for £900?

– If it is priced at £1100?

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Duration

• As we have seen, bonds have value from two sources: coupons and return of principal.

• Intuitively, bonds with high coupon rates or short maturities will return value more quickly than those with low coupons or long maturities.

• At the extreme is a zero coupon bond, which returns all value at maturity.

• Duration is a measure of how quickly the (present) value of a bond is returned.

263

Duration

• To calculate duration:– Find the present value of each cash flow individually– Sum these to get the present value of all cash flows (price)– Calculate the proportion of the total value from each individual cash

flow– Multiply each proportion by the corresponding number of periods and

sum

• The answer will give a measure of the average life of the bond in a present value sense.

• A bonds with a low duration gets most of its value from cash flows occurring early.

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BOND THEOREMS• Theorem-1- If the MP of the bond increases, the YTM would

decline & vice versa.• Theorem-2- If the bond’s YTM remains the same over its life,

the discount or premium depends on the maturity period.• Theorem-3- If a bond’s YTM remains constant over its life,

the discount or premium Amount will decrease at an increasing rate as its life gets shorter.

• Theorem-4- A raise in the bond’s price for a decline in the bond’s YTM is greater than the fall in the bond’s price for a raise in the YTM.

• Theorem-5- The change in the price will be lesser for a % change in the bond’s yield if its coupon rate is higher.

265

Bond Theorems- Simplified Version

• Price and interest rates move inversely.• A decrease in interest rates raises bond prices

by more than a corresponding increase in rates lowers price.

• Price volatility is inversely related to coupon.• Price volatility is directly related to maturity.• Price volatility increases at a diminishing rate

as maturity increases.

266

Illustration of Bond Theorems

• A decrease in interest rates raises bond prices by more than a corresponding increase in rates lowers price. This is known as convexity.

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

4% 6% 8% 10% 12% 14% 16%

Interest Rate

Bo

nd

Pri

ce

30 yr, 15%

30 yr, 10%

20 yr, 10%

10 yr, 10%

30 yr, 5%

267


• Price volatility is inversely related to coupon.

-40%

-20%

0%

20%

40%

60%

80%

100%

4% 6% 8% 10% 12% 14% 16%

Interest Rate

Pri

ce

Vo

lati

lity

(|%

Ch

an

ge

fro

m p

ar|

)

30 yr, 5%

30 yr, 10%

30 yr, 15%

268


• Price volatility is directly related to maturity.• Price volatility increases at a diminishing rate as maturity

increases.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

4% 6% 8% 10% 12% 14% 16%

Interest Rate

Pri

ce

Vo

lati

lity

(|%

Ch

an

ge

fro

m p

ar|

)

30 yr, 10%

20 yr, 10%

10 yr, 10%

269


• Price volatility is directly related to maturity.• Price volatility increases at a diminishing rate as maturity

increases.


0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0 5 10 15 20 25 30

Years to Maturiy

Pe

rce

nta

ge

Pri

ce

Ch

an

ge

5% Interest Rate

10% Interest Rate

15% Interest Rate

270

The Term Structure of Interest Rate (Yield Curve)

• Most of the fund managers are concerned with 2 aspects of interest rates; the level of interest rates and the term structure of interest rate.

• The relationship between the yield and the time or years to maturity is called Term structure.

• The Term Structure is called as Yield Curve.• Assumptions:

– For analyzing the effect of maturity on yield all other influences are held constant.

– Bonds taken for analysis are generally pure discount instruments.

– The Bonds chosen do not have early redemption features.

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Rising Yield Curve

Years to maturity

Yiel

d

272

Theories Explaining the Term Structure

• Expectation Theory• Liquidity Preference Theory• Segmentation Theory

Default risk, or credit risk, is the possibility that a borrower will be unable to repay principal and interest as agreed upon in the loan document.

Reinvestment rate risk refers to the possibility that the cash coupons received will be reinvested at a rate different from the bond’s stated rate.

Interest rate risk refers to the chance of loss because of adverse movements in the general level of interest rates.

Fixed Income Security Risk

A set of relationships among bond prices, time to maturity, and interest rates is widely referred to as Malkiel’s theorems.

Theorem one: Bond prices move inversely with yields.

Theorem two: Long-term bonds have more risk.

Theorem three: Higher coupon bonds have less risk.

Interest Rate Risk : Malkiel’s Theorems

Theorem four: The importance of theorem two diminishes with time.

Theorem five: Capital gains from an interest rate decline exceed the capital loss from an equivalent interest rate increase.

Bond A: matures in 8 years, 9.5% coupon Bond B: matures in 15 years, 11% coupon Which price will rise more if interest rates fall?

Apparent contradictions can be reconciled by computing a statistic called duration.

Interest Rate Risk : Malkiel’s Theorems

Duration is not limited to bond analysis. It can be determined for any cash flow stream.

Duration is a direct measure of interest rate risk. The higher it is, the higher is the risk.

Thinking of duration as a measure of time can be misleading if the life or the payments of the bond are uncertain.

Duration

For a noncallable security, duration is the weighted average time until abond’s cash flows are received.

Macaulay duration is the time-value-of-money-weighted, average number of years necessary to recover the initial cost of the security.

D

C t

1 R tt 1

N

t

Pwhere D = duration Ct = cast flow at time t R = yield to maturity (per period) P = current price of bond N = number of periods until maturity t = period in which cash flow is received

Duration Measures

277

Chua’s closed-form duration is less cumbersome because it has no summation requirement.

Duration Measures

P

R

FN

RR

RNRRC

DNN

N

t

11

112

1

where F = face value (par value) of the bondand all other variables are as previously defined.

Modified duration measures the percentage change in bond value associated with a one-point change in interest rates.

Duration Measures

PR

NC

R

C

R

C

RPdR

dPN

N 1

11

2

11

112

21

1

21 R+

DD Macaulay

modified

Effective duration is a measure of price sensitivity calculated from actual bond prices associated with different interest rates. It is a close approximation of modified duration for small yield changes.

Duration Measures

Deffective

P PP0 R R

where P- = price of bond associated with a decline of x basis points P+ = price of bond associated with a rise of x basis points R- = initial yield minus x basis points R+ = initial yield plus x basis points P0 = initial price of the bond

280

The price value of a basis point is the dollar price change in a bond associated with a single basis point change in the bond’s yield.

Dollar duration determines the dollar amount associated with a percentage price change.

Duration Measures

Ddollar = - x modifiedduration

bond price as apercentage of par

Pnew = Pold + (Ddollar x change in yield)

Duration is especially useful in determining the relative riskiness of two or more bonds when visual inspection of their characteristics makes it unclear which is more vulnerable to changing interest rates.

Applying Duration

The yield curve experiences a parallel shift when interest ratesat each maturity change by thesame amount.

Graphically, duration is the tangent to the current point on the price-yield curve. Its absolute value declines as yield to maturity rises.

Duration is a first derivative statistic. Hence, when the change is large, estimates made using the derivative alone will contain errors.

Problems with Duration

The bond price - bond yield relationship is not linear.p

rice

yield to maturity

Convexity measures the difference between the actual price and that predicted by duration, i.e. the inaccuracy of duration.

The more convex the bond price-YTM curve, the greater is the convexity.

Convexity

N

tNt

t

R

FNN

R

Ctt

PConvexity

122 1

1

1

11

Price forecasting accuracy is enhanced by incorporating the effects of convexity.

Suppose a bond has a 15-year life, an 11% coupon, and a price of 93%. Macaulay duration = 7.42, yield-to-maturity = 12.00%, modified duration = 7.00, convexity = 97.71.

If YTM rises to 12.50%, new price= 89.95% Actual price change = - 3.28% Price change predicted by duration = - 3.50% Price change predicted by duration and convexity = - 3.38%

Convexity : An Example

No matter what happens to interest rates, the bond with the greater convexity fares better. It dominates the competing investment.

Using Convexity

yield to maturity

bo

nd

pri

ce

Management Strategies

An active strategy is one in which the investment manager seeks to improve the rate of return on the portfolio by anticipating events in the marketplace.

A passive strategy is one in which the portfolio is largely left alone after its construction. Changes are made when securities mature or are called, but normally not for any other reason.

Classic Passive Management Strategies

A laddered strategy distributes fixed income dollars throughout the yield curve.p

ar

va

lue

maturity

maturity

pa

r v

alu

e

A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturities.

On the other hand, a credit barbell is a bond portfolio containing a mix of high-grade and low-grade securities.

If durationladdered portfolio > durationbarbell portfolio ,

rising interest rate falling interest rateinterest rate barbell ladder risk favored favored

reinvestment barbell ladder rate risk favored favored

The Risk of Barbells and Ladders

Yield curve inversion means short-term rates are rising faster than long-term rates. Duration as a pure measure of interest rate risk only works for parallel shifts in the yield curve.

Indexing is predicated upon managers being unable to consistently predict market movements.

Indexing involves attempting to replicate the investment characteristics of a popular measure of the bond market.

The two best-known bond indexes are probably the Salomon Brothers Bond Index and the Lehman Kuhn Loeb Bond Index.

Passive Management Strategies

Active management techniques frequently involve a bond swap, which is usually intended to do one of four things:1. increase current income2. increase yield to maturity3. improve the potential for price appreciation with a decline in interest rates4. establish losses to offset capital gains or taxable income

Active management strategies fall into four broad categories.

Active Management Strategies

Duration management techniques involve creating a structured portfolio - a collection of securities with characteristics that will accommodate a specific need or objective.

A key concept is immunization - a technique that seeks to reduce or eliminate the interest rate risk in a portfolio.

Bank immunization is achieved when the total dollar duration of a financial institution’s rate sensitive assets equals the total dollar duration of its rate sensitive liabilities.

Strategy 1 : Duration Management

Bullet immunization seeks to ensure that a specific sum of money will be available at a point or series of points in the future. Cash matching is the special case when cash is generated exactly in line with cash demands.

Another practice, known as duration matching, aims to get interest rate risk and reinvestment rate risk to cancel each other out.

A dedicated portfolio is a separate portfolio that will generate cash equal to or greater than some required amount.

Strategy 1 : Duration Management

Strategy 2 : Yield Curve Reshaping If lower interest rates are expected, long-

term premium bonds may be exchanged for long-term discount bonds, for example.

Strategy 3 : Sector Selection Differences in market sectors sometimes

cause otherwise similar bonds to behave differently in response to market changes.

Strategy 4 : Issue Selection Analysts try to correctly anticipate bond

rating changes or make profitable substitution swaps.

Active Management Strategies

Mba fm 02 - security analysis and portfolio---introduction

Economy & Finance

Transcript of Mba fm 02 - security analysis and portfolio---introduction